VOLUME 27 | NUMBER 1 | WINTER 2015 Journal of APPLIED CORPORATE FINANCE In This Issue: Corporate Risk Management Risk-Taking and Risk Management by Banks 8 René M. Stulz, Ohio State University Risk Management by Commodity Trading Firms: The Case of Trafigura 19 Craig Pirrong, University of Houston How to Strengthen the Regulation of Bank Capital: Theory, Evidence, 27 Shekhar Aiyar, International Monetary Fund, and A Proposal Charles W. Calomiris, Columbia University, and Tomasz Wieladek, Bank of England When One Size Doesn’t Fit All: Evolving Directions in the Research and Practice of 37 Anette Mikes, HEC Lausanne, and Robert S. Kaplan, Enterprise Risk Management Harvard Business School Evidence of the Value of Enterprise Risk Management 41 Robert E. Hoyt, University of Georgia, and Andre P. Liebenberg, University of Mississippi Here We Go Again…Financial Policies in Volatile Environments: 48 Marc Zenner, Evan Junek, and Lessons For and From Energy Firms Ram Chivukula, J.P. Morgan Corporate Hedging of Price Risks: Minimizing Variance or 57 Tom Aabo, Aarhus University, Denmark Eliminating Lower-Tail Outcomes? OTC vs. Exchange Traded Derivatives and Their Impact on 63 Ivilina Popova, Texas State University, and Hedging Effectiveness and Corporate Capital Requirements Betty Simkins, Oklahoma State University Valuing Emerging Market Equities— A Pragmatic Approach 71 Niso Abuaf, Pace University and Ramirez and Co. Based on the Empirical Evidence A Practical Guide for Non-Financial Companies When Modelling 89 Lurion De Mello and Elizabeth Sheedy, Macquarie Longer-Term Currency and Commodity Exposures University, and Sarah Storck, Technical University Munich Renewable Energy with Volatile Prices: Why NPV Fails to Tell the Whole Story 101 Ricardo G. Barcelona, King’s College, London and IESE Business School Real Options in Foreign Investment: A South American Case Study 110 Michael J. Naylor, Jianguo Chen and Jeffrey Boardman, Massey University How to Strengthen the Regulation of Bank Capital: Theory, Evidence, and A Proposal by Shekhar Aiyar, International Monetary Fund, Charles W. Calomiris, Columbia University, and Tomasz Wieladek, Bank of England his paper addresses questions of prudential capi- of safety nets that protect bank creditors creates potential tal regulation that are critical to regulatory subsidies, and hence inducements, for risk-taking that have BT policy. We begin by summarizing theoretical led bank managers to game the safety net by increasing cash perspectives on the role of capital in banking, flow risk while maintaining only the minimum amount the need for regulation of bank equity capital ratios, and the of capital;3 and (3) bank managers may face incentives to costs and benefits of raising minimum equity capital ratio increase risk at the expense of shareholders if managers obtain requirements. Next we discuss some empirical evidence about “private benefits” from maintaining high default risk and if the costs and benefits of such capital requirements; and in the the prudent management of risk in the interest of shareholders light of such evidence, we assess the adequacy of the current cannot be contractually specified and enforced. requirements. Third and last, we identify the pitfalls of today’s main regulatory approach of relying on book equity require- What Are the Social Costs of Raising Minimum Bank ments, and then propose a way of avoiding those pitfalls that Equity-to-Asset Ratios? combines the continued use of minimum book equity ratio The social costs of raising equity requirements consist of requirements with other tools, notably contingent capital (or two types: (1) those borne within the financial system, nota- CoCos) and required cash holdings.1 bly in the form of inefficiencies and other expected negative effects on banks’ profitability and values that can be attrib- What is The Role of Bank Equity? uted to required equity capital ratios that are either too low or Equity serves two crucial functions in banks. It is a first too high; and (2) costs borne by the non-financial sectors— absorber of losses, which reduces the risk of default on senior especially would-be bank borrowers—when excessive equity (debt) financing. By so doing, it reduces the exposure of the requirements result in reduced lending. The latter category insurers of those debts in the presence of a public safety net. represents social costs only to the extent the borrowers’ proj- Perhaps equally important, an adequate equity cushion— ects are worth funding (have positive net present values) and defined as a sufficient amount of equity relative to the risk of would not be funded in the absence of bank credit. a bank’s assets—also provides the top managements of banks We emphasize that the social costs we focus on in no with stronger incentives for effective risk management.2 way depend on the existence of tax deductions for borrowers’ What is the Role of Setting Minimum Equity-to-Asset interest payments, or on the existence of safety net subsi- Ratio Requirements as Part of Prudential Bank Regula- dies that encourage debt. Of course, we recognize that the tion? deductibility of interest payments will influence the optimal Left to their own devices, the bank executives who combination of debt and equity. And government protec- decide banks’ capital structure may not have incentives to tion of banks generally encourages banks to increase their raise sufficient equity relative to debt. This can occur for at subsidized default risk (to take advantage of the subsidy).4 But least three reasons: (1) bank failures may have social costs— economic theory points to other, more fundamental influ- “externalities” such as those related to contractions of credit ences on banks’ capital structure decisions. Such influences supply or disruptions of the payment system—that are not help explain why banks have chosen for centuries to operate borne by the providers of bank funding; (2) the presence with more leveraged capital structures and greater reliance 1. This is a shorter, less technical version of the authors’ paper, “A Primer on Bank 3. For a brief list of the relevant studies, see Calomiris and Haber (2014), pp.461- Capital: Theory, Empirics, and Public Policy, which was published by the IMF Economic 462. Review. The views expressed herein are its authors’, and do not necessarily represent the 4. As described by Robert Merton (1977) and documented in numerous empirical views of the International Monetary Fund or the Bank of England. The authors thank Luc studies. Two particularly influential ones are Demirguc-Kunt and Detragiache (2002), Laeven and Lev Ratnovski for helpful comments on an earlier draft. and Barth, Caprio, and Levine (2006). 2. Provided also that the bank manager’s incentives are aligned with equity owners. See Calomiris and Kahn (1991); Holmstrom and Tirole (1997, 1998); Calomiris, Heider and Hoerova (2014). Full citations of all articles are provided in the References at the end of the article. Journal of Applied Corporate Finance • Volume 27 Number 1 Winter 2015 27 on short-term debt than non-bank corporations, often in tion costs are reflected, first and foremost, in the significant environments where debt conferred no tax advantage or safety negative average market reactions to the announcement of net subsidy on banks. equity offerings.8 To the extent the price drops force issuers In their recent and much publicized book, Anat Admati to raise equity at prices that are well below fair value, such and Martin Hellwig argue that leverage choices in banking offerings end up “diluting” the value of existing shareholders. are irrelevant in the sense that such choices are unlikely to In addition to these “adverse selection” or “signaling” costs affect the activities or value of banks, apart from the benefits associated with raising equity,9 operating with equity ratios of tax deductions and safety net subsidies.5 But in making this that are “too high” can have undesirable effects on managerial argument, the authors’ analysis is based on a critical misread- efficiency—consequences that are well understood by inves- ing of finance theory—specifically, their assumption that tors, and almost certainly part of the explanation for their the total costs to banks of their capital structure choices are negative reaction to such offerings under normal circum- limited to just the returns expected by their investors. In the stances. In the case of banks, although moderate increases words of Admati and Hellwig, “The cost of equity essentially in equity requirements are likely to encourage better risk corresponds to the returns that corporations must provide to management, requiring banks to hold too much equity is shareholders to justify the money it has received from them.”6 likely to create significant agency problems by insulating bank But for issuers of equity, there are other important costs—and managers from market pressures and thereby blunting the benefits—associated with capital structure choices that are urgency of their push for efficiencies.10 only indirectly related to the returns expected by investors. In sum, the expected consequences of different capital And for that reason, the costs to a bank of issuing equity and structure choices have the potential to make the cost of issuing the expected return received by equity investors who buy the equity considerably greater than the expected return earned by new offering can diverge significantly. equity investors. What’s more, recognizing the consequences In fact, one might describe the main subject of the entire of its financing choices for the overall value of a bank has been literature on capital structure choice in banking, and in the unifying theme of theoretical models of optimal capital corporate finance generally, as thedifference between the costs structure in banking.11 As this theory implies, there is a lever- a firm experiences as a result of its decision to issue a given age ratio—or, alternatively, a ratio of equity to total assets—for security—both when announcing that decision and later as a each individual bank that can be expected to maximize its value.